After I wrote an article about capitalizing borrowing cost, I got a lot of e-mails asking me actually HOW to account for loans that do not bear the interest rate reflecting market conditions.

In other words, how to account for loans at below-market interest rate, or even interest-free loans.

Such advantageous loans are seen in many circumstances:

They are provided by a government to support some activities, such as construction of some assets, creation of employment, reimbursement of operating expenses;

They can be provided by an employer to its employees as one form of employee benefits;

They can be as well provided by a parent to its subsidiary (or vice versa) in order to support global business, etc.

In today’s article we will focus on the loans provided to the employees, but you can apply measurement criteria to other types of “advantageous” loans, too.

What rules do apply here?

Any loan provided to anybody meets the definition of a financial instrument under IFRS 9 Financial Instruments (and IAS 39, too). Therefore, we will be looking at the rules for initial and subsequent measurement of financial instruments.

We will assume here that the loans are not connected to some share purchases or anything like that and therefore we will focus on IAS 19 Employee Benefits.

To break the transaction into small easy pieces, let’s come up with a simple example:

Practical example – question

On 1 January 20X1, Goodie Ltd. provided a loan to its employee Mr. Jones amounting to CU 20 000 at interest rate of 1% p.a., repayable in 3 installments of CU 6 800 on 31 December 20X1, 31 December 20X2 and 31 December 20X3. (Note: if you discount 3 payments of 6 800 at 1 %, you should arrive to CU 20 000).

The market interest rate on similar loans is 5%.

How should Goodie Ltd. recognize and measure this loan initially and subsequently?

Initial recognition and measurement of an employee loan

As I wrote above, any loan meets the definition of a financial instrument under IAS 39 or IFRS 9. Both standards require measuring the financial assets initially at their fair value (plus the transaction cost in some cases).

Let’s say that Goodie Ltd. classifies the loan at amortized cost under IFRS 9 (or into “loans and receivables” category under IAS 39).

If the loan would have been made on market terms, then clearly, its fair value at inception would have equaled the loan amount of CU 20 000.

But this is NOT the case.

So what is the fair value of the employee loan?

In order to determine the fair value of the loan, Goodie Ltd. needs to take the following steps:

Discount all cash flows from the loan with the market interest rate to arrive at their present value.

The present value of all cash flows is the fair value of the loan.

There are few methods of discounting. Here, let’s apply simple Excel formula “PV” or “present value”, as the cash flows or installments are the same each period. Simply type =PV in the excel file and insert the following parameters:

Rate = 0.05 (that’s for 5% being the market interest rate)

Nper = 3 (for 3 regular installments)

Pmt = – 6 800 (that’s how much employee will repay in each installment)

Fv = 0 (the future value after repayments, in this case 0)

Type = 0 (payments are made at the end of period)

Your formula should look something like =PV(0.05;3;-6800;0;0) and if you did it right, the fair value of the employee loan is CU 18 518.

You can do this calculation also in the table format, using the discount factors for the individual year – up to you. I elaborate more on this in my premium training package The IFRS Kit, so if interested, please check it out.

How to treat the difference between loan’s fair value and nominal amount?

There’s a difference between:

The nominal amount of the loan (or the cash paid to an employee): CU 20 000, and

The loan’s fair value of CU 18 518

Difference = CU 1 482

Normally, this would be recognized directly in profit or loss, but here’s the trick:

This difference is an employee benefit and Goodie Ltd. must recognize it in line with IAS 19 rules.

The problem is that IAS 19 does NOT provide any direct guidance on accounting for this form of benefits, and therefore we need to apply general principles of IAS 19.

Determine the type of the employee benefit

First of all, we need to determine the type of the employee benefit under IAS 19 and it depends on the specific terms of the loan agreement.

You should seek answers to the following questions:

What happens when the employee leaves the company? Can he still keep the loan at favorable conditions and continue paying beneficial interest? Or will he need to start paying the market interest rate? Or will the loan become repayable?

If the employee can continue with the loan under the same favorable conditions even after he terminates the employment, it means that the employee benefit has already been earned.

In practical terms – it is recognized straight in profit or loss and the journal entry is:

Debit Profit or loss – Employee benefits: CU 1 482

Debit Financial assets – Loans: CU 18 518

Credit Cash: CU 20 000

If the loan will revert to a market interest rate after the employee leaves, then the benefit has not been fully earned and is available only while the employee provides services to the entity.

In line with IAS 19, an expense should be recognized when the employee provides its services, therefore in this case, we cannot recognize the full amount of CU 1 482 in profit or loss at the time of making the loan.

Instead, we need to defer the expense and allocate it to the periods when the employee provides services.

The journal entry is:

Debit Prepaid (deferred) expenses for employee benefits: CU 1 482

Debit Financial assets – Loans: CU 18 518

Credit Cash: CU 20 000

Amortize the benefit in profit or loss

Then you need to determine HOW you will amortize these prepaid expenses in profit or loss.

Here, several methods are acceptable, but let me show you the method I have seen very frequently. This method looks at the employee benefit as short-term benefit, i.e. settled within 12 months after the employee renders the service.

You can estimate the cost of such an employee benefit in each period as the difference between:

The interest income for the period based on the fair value of the loan asset (using effective interest method at the market rate of 5%); and

The interest payable by the employee (at 1%).

I have prepared the simple calculation in the following table:

The specific numbers depend on the year. Let’s draft the journal entries at the end of the year 1:

#1 Interest income on the loan using the effective interest method (at 5%):

Debit Financial Assets – Loans: CU 926

Credit P/L – Interest income: CU 926

#2 The 1st installment paid by the employee:

Debit Cash: CU 6 800

Credit Financial Assets – Loans: CU 6 800

#3 The employee benefit resulting from the employee loan:

Debit P/L – Employee benefits: CU 727

Credit Prepaid (deferred) expenses for employee benefits: CU 727

Any questions or notes? Please leave me a comment right below this article and don’t forget to share it with your friends – thank you! 🙂

Hi Anil,
this is regular interest income charged using the effective interest method (at 5%). Look at the table above, the first part – columns “5%”, specifically at interest income. You will find exactly 926 for the first year – that’s by how much you should increase the loan recognized initially and it represents the market interest. Basics of the effective interest method are fully explained in the IFRS Kit, too. Have a nice day! S.

Dear Tenzin,
please read the last part of the article “Amortize the benefit in profit or loss”. In the first year, you amortize 727 (the last entry). In the second year you amortize 499 and in the third year 257 – it’s seen in the table above. Still the same entry. S.

Then the process is very similar. If you change the interest rate on your loan to employees, you discount the loan with the new rate and you update the amortized cost table and the amount of benefit. S.

Hi Johnny,
the entry above is correct. Even if the loan is interest-free, you need to recognize it at fair value (which is NOT the same as cash you gave to employee) and then you charge market-rate interest income on the loan – that’s the basics from the effective interest method. S.

Many thanks for such a beautiful article on a very regulary faced situation.

I just wanted to ask in which situations should we defer the diff i.e. 1482 in above example and when should it be charged upfront on day 1 ? ( if we apply the same prinipll for loans/ deposits etc which are either interest free or at discounted rate)

Further if we see the net impact on the income statement is NIL because of fair valuation.(In year 1, Before fair value interest income 199, After fair valuation (Int Income 926 – AMortisation 727, Net 199.

Yes, in the situation when you don’t charge the difference immediately. However, the presentation matters, because you are not showing 727 net in the interest income, but separately as an employee benefit – and that’s the significant and important information for readers of the financial statements. S.

Hi Sumit,
maybe I did not explain it clearly – but I tried to write above that if the benefit has already been earned and employee can keep the low interest loan even after he terminates, then the difference of 1482 goes straight in expenses in P/L at initial recognition.
If an employee loan reverts to market rate loan after employee leaves, then the difference is amortized.
S.

I am from the banking sector, my treatment for loans given to staff members at a subsidised rate.

Step 1. Mark the loan to market and establish the differential amount of interest .Lets say its USD 1000

step 2. Since the bank would have received this as interest income(USD 1000) we credit the interest income(P&L) therefore the overall interest income is increased by the interest differential amount(USD 1000)
Step 3. Debit the Staff costs/interest expense account(P&L) with the amount (USD 1000) of subsidy (differential interest). this increases the amount of interest expense for the Bank because the Bank bears the cost of giving loans to staff members at below market rates

Result: The amounts net off in the P&L
Debit: Interest income with USD 1000
Credit: Interest expense/Staff costs USD1000

Hi Kapembwa,
A few things are unclear to me in your approach. E.g. in the step 2 – when do you credit the interest income? Upon initial recognition? Can you write up the journal entries to make it clearer – over the life of the loan? S.

Thank you for explaining it in a very simple way.
I have a question about interest free loans to employees for one year only. Employees can take housing loan anytime during year and is deducted on monthly basis from payroll.
How to treat it?
Thank you

Yes, of course, you should, because the basic idea is to bring the loan at its fair value. If it’s not at fair value (as it’s below market interest), then you will have a difference and in this case, income statement is always involved. From practical point – if the loan is for less than 12 months and is provided and repaid within the same reporting period, then it does not make a big deal (impact on the income statement “clears” within the same period). Other than that, you should be doing the same thing as I wrote above in the article. S.

My question is if under a country policy to increase economic activity, a Company get a loan from a bank using an interest-below market conditions. For instance, the market interest rate is 10%, but the company obtained the loan at 6% interest rate.

Should the difference in the interest rate treat under IAS 20?How do you treat the interest below market conditions?

Hi Gaston,
so you are basically asking about the same thing, just on the liability side. Yes, you should initially recognize the liability at its fair value – which is a discounted cash flow at the market interest rate of 10%. The difference should be recognized in profit or loss, but if it is a form of a government grant or assistance (it’s not clear from your question), then the difference is treated either in profit or loss, or amortized over the period of meeting the conditions for the grant (very simply said). It also depends on the purpose of this loan (capital investment? OPEC?) S.

Hi Silvia,
In relation to this topic in a scenario where say the Market rate is 10% and a subsidiary gets loan from the Holding co at market rate plus say 5%. In such a case the FV is less than the loan amt. Are there any adjustments to be made as per IFRS 9.
Thanks
Dipanjan
Botswana

Hi Dipanjan,
it’s very similar as for the below market rate. You simply discount the future cash flows from the loan by the market rate of 10% – this would be the fair value and any difference is recognized in profit or loss (I guess that would be the loss for the borrower and the profit for the lender). S.

from the practical point of view: if its within 1 reporting period, then I would not do it. But if the loan is not repaid at the end of the reporting period and it’s material in aggregate (if you provided more employee loans), then yes, you would need to calculate FV.
S.

In regards to the Dr: repaid (deferred) expenses for employee benefits: CU 1 482, I assume that this is regarded immediately as an asset and then half of it being recognised in P&L by the end of yr1. (assuming that the benefit is conditional on employee being employed for a total of 2 yrs). However, how can this deferred expense be regarded as an asset, since I cannot see how it meets the framework’s definition of an asset, i.e. “Resources controlled by the entity..”? How this can be assessed as resource?

Thank you for article. This time I would disagree with you a bit.
When the market rate is 5% and we have 1% loan, we shall discount at 4% not 5% (the difference between market rate and the loan actual rate). If we disount at 5%, then when we unwind the amortized cost, we will get 6% interest in our PL, which is not correct. Since the idea is to have the market interest rate of 5%. Therefore we shall discount at 4% to come to the market rate of 5%. The fair value of 5% loan in amount of 20,000 will be 20,000.
We did it always like this when preparing FS in BIG4.

Dear Olga,
I don’t think you understood my example fully, as the treatment you suggest is not correct for this particular situation. Here’s why:
– you do NOT discount the amount of 20 000, but 3 installments of 6 800 = CU 20 400.
– if you discount the total amount of 20 400 (by installments) with 4%, that would NOT be the fair value of the loan, but you would get higher amount than CU 18 518. Also, your presentation would be wrong, because you should present the interest income at 5% and the differential of 4% as some employee benefit cost as stated above.
– if the loan carries a below-market interest rate, there is no chance that it’s fair value upon initial recognition equals to the cash provided (as you suggested: FV of 20 000 loan = 20 000 – no way at below-market interest rate loan). Please refer to IFRS 13, more specifically present value techniques.
– if you discount with 5%, you do unwind at 5% and book unwinded interest of 5% – not 6%. 1% is interest used in calculating the cash flows from the point of view of employee, but that’s another thing. You do NOT book the interest at 1% anywhere.
Please, do your calculations in the excel file and if you want, send them to me and I’ll comment on it. But I did my calculations exactly in line with the above method and everything was mathematically correct, just see above. By the way – what I saw from Big4 audited accounts, was exactly the approach illustrated in the article.
All the best
S.

Thank for your reply. Be honest, I found when rereade the article at the second time that during the first screening the article I was not very attentive and missed some key information. Now I agree with your examples.

Company in the past had provision for warranty equal to 5% of sales made during the year.directors like to increase provision to 8% of sales during the year.provision for warranty has the current balance of $12,000 which is the carried forward balance from 30th June 2014. Sales for the year ended 30th June 2015 is 460,000. Company is finalising its financial statement for the period ending 30th June 2015. Can you please tell me the appropriate accounting treatment of this accounting estimate?

Dear Ajit,
is this a change in accounting estimate due to some changes during the year? Or did the management forget to do it in the last year?
In the first instance, you should treat the change prospectively, in the second instance, retrospectively as a correction of error. S.

I faced the similar situation in one of my previous companies wherein the Employees were given interest-free loans repayable in installments and we had to discount the expected cash flows by using a discount rate and then charge the difference to P&L as Employee Benefit and place the same in a negative Reserve/Provision against the Loans & Receivables. Every year the Reserve is reviewed and adjustments are dealt with accordingly (either reverse or increase the Reserve)

Lot of thanks, i found answer to my query on how to account for difference between fair value of loans & amount actually paid for the loan.
It is strange that IFRS 9 does not contain any guidance on this aspect or does it?
Thanks again

Thanks for this article. I was wondering your thoughts on something such as Student Loans which are offered at below-market rates of interest (so effectively a loan subsidy). How would these be treated under IFRS 9?

Hi Silva,
Thanks for simplifying the topic. My concern is where an entity did not go by your approach but was only recognising the contractual income, is it acceptable to also calculate the difference between interest income at market rate and the concessionary rate and then crediting income and expense with this difference (by way of IFRS adjustment)? Thanks

If we assume that the market rate has changed in the 2nd year, then do we need to recompute the fair value of the interest income in 2nd year or we can leave it and continue with the same table above mentioned in entire 3yrs period.Will it be acceptable??

Dear Navaneethan,
the loan should be classified at amortized cost, so in fact, the change in market rate in the 2nd year is not interesting for the purpose of fair value determination. (Yes, you can opt to measure employee loans at FVTPL, but it’s very impractical for most companies). Therefore, even when market rate changes, you continue in line with the above table as you measure your loans at amortized cost. S.

No, your question was not missed. Comments do not appear immediately, because administrator needs to approve them due to lots of spammers on the website – sorry for that. Also, if you are IFRS Kit subscriber and you lost your log in, please contact us via contact form and we will help 🙂 S.

Hello,
at the end of 3rd year, it will be zero. The reason is that the very first entry was to Debit Prepaid expenses with 1482 (please see it right above the title “Amortize the benefit in profit or loss”). When you amortize, you gradually credit this account until it’s zero.
S.

Hi Silvia, thank you for this as it is a very helpful explanation. However, I was wondering why the example has an interest rate of 1% stated in it when it also already gives the periodic repayments as 6,800. Except the 1% is not a contractual interest rate charged on the loan amount of 20,000 (because if we use the annuity calculation to discount the payments as said in the example, we would arrive at 20,000) then I don’t get that part especially when the 1% interest would give us 200 * 3 interest payments. We would then get 600 (interest) + 20,000 (principal) = 20,600 cash flow as opposed to 6,800 * 3 = 20,400 cash flow, from the example.

In case you don’t understand, the whole point of my question is “Did you use 1% in calculating the interest contractual cash flows?”. The principal should be add up to 20,000 in any circumstance.

Joshua,
sorry for the later response.
I stated the interest rate of 1%. because it’s the internal rate of return of cash flows.
Also, your interest cannot be 200*3 – remember, you do not calculate interest from the principal in the beginning, but this principal decreases with each payment. So yes, while the first interest will be 200, the second year interest will be only (20 000-(6800-200))*1%.
S.

Silvia, I supposed you failed to tell us that it was by coincidence that the employee benefit of 1482 is the same as the difference between the fair value of the loan and the principal. otherwise the logic you presented does not work correctly if you apply it with different figures and rates.

Dear Sulley, please re-read the article again. I did not fail to tell you anything. I clearly stated that the difference between fair value and principal IS the employee benefit. If that difference would be 3000000, then your employee benefit would be 3000000. Hope this is clear.

Could you please explain the treatment when the employee is required to pay the loan when exiting the employment? Also, would there be any difference practically if your example above met the defn of ifrs 2?

Thank you for your explanation. I need to know if employee loan should always be assessed on PV basis even when they have been granted interest free by the company? Also, I didn’t quite get at what point the deferred cost is amortized to P or L and the basis for such amortization

Hi Silvia,
great work, its so helpful.
One doubt that i have is, what if the employee after termination doesn’t repay anything.
A provision is being created for the outstanding amt but we know it won’t be repaid.

Thanks for the simplest clarification on a complex topic. Just 1 query, will the Financial asset be booked and kept at a lower value i.e. CU 18518 or will it only for internal book keeping and reporting purpose? What i mean to ask is, the employee will see this amount or CU 20000 in his loan books?

Hello Sylvia. I just stumbled on this narrative explanation on treatment of below the market or interest free employee loan. I will like to ask how the treatment of fund deducted by employer from employees pay and held till staff leaves the employment (which in this case could not be determined) will be recognized in line with IFRS. Kindly note that the employer did not secure any loan from banks.

Hi Yomi, technically speaking, it’s a “long-term” loan from the employee and it should be discounted (you should estimate the average period of the employment…). But, is it material – individually and in their aggregate value? If not, then just leave it as it is.

I have one query is salary advance to staff with in category of loan under financial instrument. IN my company staff is entitiled for two month advance wjich can be dedcut in 10 monthly instalment in any how all dues must be settled on or before 31st Mar. Please clarify if such advance will fall under financial instrument or nor mal advance to party as we are giving to our vendor for services in the similar way salary is advance given for services to be rendered in future

Do I treat loans made to employees to buy company shares as an employee benefit if the interest rate charged to is below market rate. So conditions are (a) employee can make a loan to buy company shares and pay 1.5% interest (b) loan is repayable at any point but must be repaid on the earlier of leaving the company, selling matched shares or at end of loan period. At each accounting period after initial recognition should these loans be measured at FV (IAS39). What about discounting? Bit confused here because there is both an employee benefit and SBP involved.

Hi
Please help me with the following:
While lending a employee loan let say i am lending at a concessional rate of 6% p.a. fixed rate for 5 years where els the same nature of loan with same credit rating is provided in market @ 10% p.a. variable rate (which will reset every year). In such a case while initial recognition, can i consider the same 10% rate for arriving at fair value? will 6% fixed rate be comparable to 10% variable rate??

I have one query in your example. Expenses for Employee Benefits which is 1482 at the beginning. Can we debit the Employee Benefit expenses at the year end 1,2 & 3 CU 494 each year on straight line basis ?

Whether it is appropriate to expense out to P/L Account the difference between FV and loan amount CU. 1,482 directly whether it is in compliance with IAS -39/IFRS-9. Please explain and provide me any reference of this in IAS -39/IFRS-9. Thanks.

Sylvie, I have purchased your IFRS kit package, but did not find the table above for this example in any of the excel spreadsheets. Can you let me know which excel spreadsheet is the above example and the table illustrated in?

It was very helpful. and further let me know, If an employee make the balance capital payment to settle the balance & mgt is ok to proceed with it. how do we recognized the interest income which should have been received under normal conditions but not received due to above reason.
1. Cash dr (capital balance)
Loan receivable Cr

Hi Silvia,
thank you very much for this topic. I have one question regarding the last table: could you please tell me what formulas did you use for the columns of B and E? Interest income and interest payable?
Thank you$regards

Your article is really helpful. I sincerely admire the way you explain each and every point. I just have a simple query that whether deferred tax to be created on the entries of deferred employee cost amortised and notional interest income booked .

Hi,Silva
What is the accounting implication or treatment when employees salaries are being paid before month end. Does IAS 19 or any other standard address this situation? Your prompt response will be highly appreciated

If a Parent company gives Interest free loan to Subsidiary and there is no period defined till when the loan will be repaid. In an agreement its mention payable on demand.

Kindly advise whether we need to recognise the loan at fair value.

As per IFRS there is no specific guidance.As per IFRS/Indian Accounting Standards (Ind AS) “The fair value of a financial liability with a demand feature is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid. Since it is repayable on demand at any time, no discounting would be required on initial recognition.”

Hi Silva,
since the fair value of loan is less than the actual loan given in initial phase, is it right for me to understand that as loan is being issued at concessional rate, so the fair value is less than actual loan given,there fore its a part of expense, please correct me silva

Hello Silvia,
Thank you for the example. Before looking at your solution, I had tried on my side. The result is the same except for the allocation of the 1,481 over the 3 years. I had taken the fact that employee received 20K in cash but did not pay enough interest. Thus, taking the discounted difference in the installment he actually paid with the beneficial 1% interest rate (6,800) versus what he should have paid with a 5% market interest rate (7,344). Resulting in Employee benefits of 518, 493 and 470. I know you mentioned that there are several possibilities. But do you see anything wrong with that ?
Thanks much

Hi Silvia
what happens on settlement date of the below market interest loan offered to the employee. i.e if the loan is settled at an earlier date than agreed upon or when there are changes in the market rate during the period of the loan, because in this case the employee benefit will not equal the fair value adjustment at initial recognition.

Hi Silvia,
Really appreciative explanation. I would like to know the treatment in the following situation:
when the loan is insured and annual insurance premium is deducted from employees’ salary and at the time of maturity, the amount received from insurance company is shared between employees and employees at certain proportion. The premium deducted is not the income of employer but only amount received at the time of maturity is income. The loan in interest free to employees but premium should be paid as deduction from salary.
Does it similar to loan with no interest rate and one time repayment (equal to employer’s share) at the time of maturity? Thank you.

please mention the journals for receiving installments from employment for the first year in case we have recognized the difference in profit or loss .
do we will reverse the amount charged before in P/L =CU 1 482 with every installment.

If a Bank offers a facility where a short term loan is offered to it’s employee under interest free arrangement. I agree that every loan is an example of financial instrument therefore the loan shall be recognized at fair value at inception plus transaction cost. While, the mark up charge for similar loan is 7.5% on the outstanding principal. The problem is how can it be accounted for under IFRS 9 Ammortized cost classification as it does not fulfill the SPPI criteria.

I appreciate your support and notes on IFRS and IAS… Simple and self explanatory… In my country jurisdiction, we are applying defined contribution plan for retires and any entity is not accountable for any shortages or benefits after retirement… Pension is managed by government agency… and any contributions are made to this agency….

But,
1. we don have some employee benefits which will be payable upon employee resignation (employee’s request) and the liability is increased and vested as employment service year increases …
i.e (last date’s salary rate*Service year)/3
2. Medical services and refunds (even after retirement)

How can i accrue and treat these benefits’ accounting annually? Shall I undertake actuarial valuation?

Silva, you are doing just fine with your explanations.
My question is a director gave an interest-free loan to the business to support the operations until the future years when the company shall be able to repay.
Shall we fair value the initial loan given in the similar manner as the example above just that this is just on the liability side?
Also, help clarify the place of ‘Day One Loss’ under the above example given by you?
Dele,Lagos-Nigeria

Hi Silvia, a company bought a vehicle for R50′ then sold it to one of the employees for the same amount (interest free). How should this transaction be captured? When will the ownership transfer to the employee? Will it only be a loan without and fringe benefit tax as it is a purchase?

Chantal, if the vehicle was sold to employee – does it mean that the control of vehicle passed to employee? Also, did the employee pay or was it on credit? not clear from your scenario. However, the vehicle is derecognized when the control passes to the employee.

hi silvia , thank you for the great job you doing in explaining debatable areas , i have a question lets consider banks make loans lower than market rate (because of governmental limitations) like a forced rate and the funds are not provided by government but own bank funds , So is this to be treated like employee loans or loans to subsidiaries?
and if it does , consider the loan is being held to maturity, you should only do the initial recognition in fair value and then continue with amortized cost method or use fair value for the life time of the loan(because the rate is not reflecting the credit risk) ?